Private Equity in Emerging Markets

John Livingston, Principal, based in the Singapore office of McKinsey and Company, talked about private equity in emerging markets at Hale Auditorium, last Friday. The talk was presented by UMBS' Center for Venture Capital and Private Equity Finance. Although John's talk focused on Asia, many of the underlying dynamics apply to other emerging markets as well. John discussed the 6 stages in capital requisition namely, seed, startup, expansion, mezzanine, buyout and turnaround. Venture capitalists focus on the startup, expansion and mezzanine stages. Over time, venture capital backed firms that go IPO have performed well. Venture capital is highly cyclical and follows the rise and fall of industry returns. When industry returns are high, supply of funds increase and vice-versa. Venture capitals are constantly looking for 'big bang companies'. 90% of fund returns come from 15% of investments. This exemplifies the significance of big bang companies with returns of the order of 100:1 or 50:1. For example, with a 30% stake, a firm's market capitalization has to be in excess of $300 million, for a $1 million investment to yield a 100:1 shot. Venture capitalists do not get overly hung up on valuations. They rather make bets on potential breakthrough concepts and technologies.

In the context of Asia, it is almost impossible to find a big bang firm with a 100:1 shot. If the big bang firms are taken out, it becomes increasingly critical to ensure that there are not too many losers in the venture capitalist's portfolio. Venture capitalists face greater challenges in emerging markets where they have to be extremely skillful in picking winners. The significance of corporate venture capital should not be overlooked, especially in Asia. In the last 5 years, corporate venture capital has grown at a 35% CAGR. Companies have more money than individuals in the emerging markets. More than half of the funds in Asia are sourced from corporations and less than 7% came from individuals. The outflow of venture capital from individuals has dropped significantly in the recent past. The infusion of money has been in existing portfolios, not in new investments.

Another difference in Asia is the exit strategy. The IPO market is extremely limited. A total of 25 stocks in Singapore and 2 in Malaysia are listed in what is regarded as the equivalent of the Nasdaq index. Traditional exit is through sale but multinational companies are pulling out fast. Capital outflow from Asia has been quick. In John's opinion, the Asian market can be broadly classified in three categories—Japan, China and the rest of Asia. Even in China, the growth in Foreign Direct Investments is falling fast. Under these conditions the viable exit option is to sell out to regional players who have cash.

As a private equity investor, Asia is a great buying opportunity. The downside is higher risk levels and much longer harvest times (7 to 8 years). There are other specific challenges in emerging markets. The start-up environment is less robust. There are fewer business plans and the quality and experience of management is poor. The technical risk is also much higher. The research performed in universities and other establishments does not compare to that in the United States. The market is not clearly defined. Further, second round funding is insufficient.

Another significant challenge in Asia is that you have to win in every market. This is difficult considering the differences in culture, language and regulation. Any particular country by itself is not big enough to be attractive. A close-knit community based phenomenon such as The Silicon Valley is absent in Asia. The activities at technology hubs such as Hsin-Chu Industrial Park, Taiwan, home to TSMC, do not transcend country borders. The political situation and government regulations in many of the emerging markets add to the challenges.

McKinsey partners with clients in Asia to do due diligence and provide ideas. McKinsey does not provide capital. Asia has over 2 billion people. There is a dramatic digital divide. Low cost technology is enabling corporate connectivity (B2B). Talking more specifically about opportunities in Asia, John mentioned wireless communication and IT services and outsourcing. China is expected to have 250 million cell phone users by 2003. IT services and outsourcing from India is expected to touch $80 billion by 2007. Both these are tremendous opportunities for private equity investments in light of corporate restructuring, market deregulation, emergence of new technologies, lack of capital in many incumbent players, capital outflow from multinational companies and the decline in the equity markets.

 
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